Last month President Obama announced his latest proposal for financial reform “to ensure that the failure of any large firm does not take the entire economy down with it.” The president promised: “Never again will the American taxpayer be held hostage by a bank that is ‘too big to fail.'”

The proposal, named the “Volcker Rule” after former Fed Chairman and Obama advisor Paul Volcker, aims at reintroducing Glass-Steagall-like restrictions on banking (as commented on by my colleague Anthony Randazzo), thereby preventing firms from growing too big (to fail) and engaging in behavior that will put the financial system, and eventually taxpayers, at risk. Or so are the good intentions.

Here is why President Obama thinks we need the Volcker Rule:

“First, we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward. And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks.”

“In addition, as part of our efforts to protect against future crises, I’m also proposing that we prevent the further consolidation of our financial system. ”

William D. Cohan, author of the best-selling book House of Cards, which explores the financial meltdown from the perspective of Bear Stearns’ collapse, is highly critical of the proposed reform. As he writes in TheNew York Times:

“The problem is that Obama’s latest proposal to try to protect us all from the threat that Wall Street might be constructing yet another financial house of cards – the so-called Volcker Plan, whereby banks such as JPMorgan Chase and Bank of America, which take customer deposits (but not Goldman Sachs, which does not), would be barred from proprietary trading, or from owning hedge funds or private equity funds – seems off base on so many important levels that it resembles the proverbial camel, rather than the thoroughbred that Obama and Volcker were no doubt hoping to create.”

The Volcker Rule, according to the president, states that “banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.”

A major goal, then, is putting a stop to “proprietary trading” for all depositary institutions (banks holding deposits, which are federally insured), i.e. from engaging in trading in securities and other financial instruments that put the bank’s own capital at risk. However, this is much harder than it sounds. Martin Wolf, chief economics commentator at the Financial Times, questions if the proposal is at all workable, doubting whether it really would be “possible to draw and, more importantly, police a line between legitimate activities of banks and activities ‘unrelated to serving their customers’.”

A significant question here is whether the proposal even addresses the main problems of the financial sector, leading up to the current mess. Cohan doubts this is the case:

“It’s worth reminding ourselves that this latest “nearly catastrophic” financial crisis – as Treasury secretary Tim Geithner referred to it today during his Congressional testimony related to the A.I.G. bailout – was not caused by Wall Street’s proprietary trading nor by its private equity funds nor by a hedge fund owned in whole or in part by a depository institution. This crisis was caused by a host of others reasons: among them, homeowners who took out mortgages they were unlikely to pay back; Wall Street securities firms that bought those mortgages and re-packaged them as securities and then sold them off to investors worldwide; ratings agencies that were paid to rate these securities AAA even though they weren’t; and regulators who either turned a blind-eye to Wall Street’s miscreant behavior either because they were underpaid and overworked or simply because one day they hoped to work at the firms they were regulating… in any event, Bear Stearns was not a depository institution. Were Bear Stearns to still exist today, the Volcker Plan would not have prevented these hedge funds from being at the firm… Indeed, one would be hard pressed to lay the blame of any of the most painful recent financial crises – the Internet Bubble, the Emerging Telecom Bubble, the collapse of Worldcom and Enron, the Asian Crisis, the Savings and Loan crisis, or the Market Crash of 1987 – at the doorstop of any of the bad behaviors the Volcker Plan is trying to curb or to prevent.”

“Moreover, the question of relevance [of the Volcker Rule] arises in other ways, too. In this crisis, at least, banks’ investments in hedge funds, private equity and even proprietary trading were simply not the core of what went wrong.”

So what then are the motives behind this latest proposal to prevent, in the president’s words, another “binge of irresponsibility” and “reckless risks in pursuit of quick profits and massive bonuses”? Wolf seems to think the motivation is mostly political, and can be found in the administration’s need to gain popular support:

“Today, the people see in the financial sector not the skilful hands of erstwhile masters of the universe, but the grabbing hands of greedy ingrates. It is little wonder, then, that a desperate President Obama, battered by the voters in Massachusetts, has turned upon a group even less popular than his party. He has duly added the axe of Paul Volcker, 82-year-old former chairman of the Federal Reserve, to the regulatory scalpel offered by his Treasury secretary, Tim Geithner.”

As these comments give witness to, the Volcker Rule has been met with mixed reactions, and a wide range of critical remarks. For one thing, the Rule doesn’t seem to be practical, in that it would be near to impossible to draw the line between when a bank is engaged in for instance legitimate hedging or investment activities “unrelated to serving their customers.”

Volcker has responded to this critique by stating that “you know it when you see it,” a rather vague notion, to put it mildly, of how both regulators and banks should respond to this rule. Princeton economist and former Vice Fed Chairman and Clinton economics advisor Alan Blinder writes in a recent Wall Street Journal op-ed:

“I am waiting to see if what is really the Volcker ‘idea’ can be translated into a workable Volcker rule. It is devilishly difficult to draw bright lines between proprietary trading and trading, hedging, and market-making on behalf of clients. Mr. Volcker himself said that ‘you know it when you see it,’ suggesting an analogy with pornography. The problem is, often you don’t.”

Another commentator writes that “you can drive a supertanker though the loopholes in this proposal” and predicts that the “Volcker rule” is probably “dead on arrival.” Felix Salmon, a Reuters Blogger, explains these loopholes:

“…the Volcker rule seems to apply only to depositary institutions: if you don’t take deposits, then you’re exempt. The result is that it’ll be easy for Goldman Sachs and Morgan Stanley to get around the rule just by returning their current (tiny) deposit base and voluntarily withdrawing from access to the Fed’s discount window… But the point here is that banks with deposit bases are already insured and regulated, by the FDIC.”

The Volker Rule would be very hard to implement and supervise. Also, given the regulatory agencies’ inability to monitor systemic risk in the run-up to the current crisis, it seems unlikely that adding a new, vaguely formulated rule would improve regulatory performance.

At a time when the financial sector and the economy are facing tremendous uncertainty, it is just not a good idea to be throwing out proposals that add confusion. Many of the plans to curb banking activity and punish the banks – such as Gordon Brown’s “global” bank tax (for G20 countries) and President Obama’s repeated attacks on the banking sector – create even more uncertainty for what the future will hold for these financial firms.

Independent Institute scholar Robert Higgs, author of several papers on the Great Depression, has shown how “regime uncertainty”, i.e. a political climate hostile to business and with changing policies and rules impacting their ability to make long term plans, was a major factor in prolonging the economic woes of the New Deal era. This, according to Higgs, “prevented a robust recovery of long-term private investment” at a time when the economy needed it the most.

As was pointed out at Davos, where this proposal was discussed during the recently held World Economic Forum, initiatives are already under way for new international standards, establishing new and improved capital rules for banks, attempting to make them “counter-cyclical” instead of “pro-cyclical”, as was the case with the much criticized Basel rules, which amplified both the boom and the bust in housing-backed securities.

Imposing a different set of rules on American registered banks, than their European and Asian counterparts, would only lead to regulatory arbitrage, and would create confusion as many of today’s financial firms operate globally, across different jurisdictions.

Related to the last point, Europeans like their big banks, and would be hard to persuade in adopting a Volcker-like rule for their own financial sectors, which would make the actual passing of the rule in the U.S. Congress a less likely outcome. It is also worth pointing out that Europe never had Glass-Steagall restrictions to begin with.

The costs this new regulatory burden would create are hard to estimate, but could be quite substantial, and should be taken into consideration, as Anthony Randazzo comments in a blog post earlier this month.

It is also worth noting, as Martin Wolf comments, “Volcker’s axe is not enough to cut banks to size”. In other words, the proposal is in no way a cure against institutions that are “too big to fail”, also because a lot of the financial firms that are “systemically important” are not banks at all, i.e. they are not depositary institutions, as the recent crisis clearly showed. Alan Blinder makes the same point, namely that “the firms that take the biggest proprietary trading risks are not banks at all-or at least not real banks, with depositors and all that. (I am not naming names.) Yet some of these firms are too big to fail, whether we like it or not. If they gamble and lose big, we taxpayers may find ourselves on the hook again, which is why we need resolution authority.”

Perhaps most importantly, Volcker’s proposal doesn’t even come close to addressing the underlying problems of the U.S. financial sector and the origins of the financial meltdown. Why not just attack the problem at its core? The central question to this whole debate on financial reform should be: What should the federal government do to unwind its formal and informal guarantees to the financial sector in a credible way, thereby eliminating the pervasive moral hazard that these guarantees create?

Volcker acknowledges this problem, expressing that a “large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions.” Sadly, his rule doesn’t even come close to tackling this problem.

A thorough reform of the financial sector would be looking at bankruptcy procedures and resolution authority for the non-bank financial firms not covered by the existing FDICIA legislative framework. Such a radical reform would of course also entail a full revision of the Fed’s mandate and actual practice of monetary policy, something which has not even been discussed so far in the deliberations on financial service industry reform.

The main lesson from this crisis should be that the Fed and the Treasury, as the two most important U.S. institutions for economic policy-making, should not create guarantees or commitments to bailing out the financial sector or creating soft landings for investors whenever a downturn hits.

The retirement benefits ultimately received by members of both plans within FRS will come at an ever-increasing cost to taxpayers and other public services if needed technical adjustments to both plans go neglected.